Description

Cal-Maine Foods (CALM) SHORT

Summary

Cal-Maine (CALM), the largest producer of table eggs in the US, is up 50% is the last 3 months and almost 3x since 2013. We think shorting the stock is attractive, either outright or through long-term puts. The company is overearning in a low-growth commodity industry due to a bird flu epidemic and other factors described below. By our estimates, the stock is trading between ~25x-~35x normalized earnings, net of 2015-2017E overearning, cash, construction in progress and other assets. Assuming a 12x multiple on normalized earnings, we believe there is ~40-50% downside for the stock, with limited long-term upside.

The Business

Cal-Maine is the largest producer and marketer of table eggs in the US with ~11% market share, mostly in the southeast (especially Florida). They focus on table eggs (as opposed to “breaker eggs” which are turned into liquid or solid egg products for commercial use). The company has been an active consolidator: they have completed eighteen acquisitions since 1989. In addition to selling commodity eggs, CALM sells specialty eggs such as cage-free eggs and nutrient enriched eggs as part of the “Eggland’s Best” consortium. The company also resells eggs from other producers under “co-pack” agreements, on which it makes a small margin. For those familiar with the broiler industry, note that CALM’s model is meaningfully more capital intensive than the typical broiler integrator since CALM owns and operates the vast majority of the facilities for raising pullets and housing layers.

Specialty eggs refer to any non-commodity eggs – these are primarily Eggland’s Best eggs and cage-free and organic eggs produced under CALM’s own “Farmhouse” brand. Eggland’s Best is a consortium collectively owned by franchisees, who pay the collective a per-egg fee for every Eggland’s Best branded egg they sell. Branded eggs are fed a specific diet to produce nutritionally enriched eggs. The collective promotes the eggs and does some R&D, returning any left-over “profit” as a patronage dividend. An Eggland’s Best franchisee has the right to sell eggs in a specific “home” geographic area as well as to sell “away” in another franchisee’s “home” territory but must pay the “home” franchisee a royalty. In practice, franchisees typically mainly sell in their “home” franchises, giving Eggland’s Best franchises elements of local monopolies (although with limited pricing power due to the close substitute of other eggs). CALM owns the “Farmhouse” brand itself, which it uses for cage-free and organic eggs, but pays Eggland’s Best to promote the brand on its behalf.

The company does not disclose profitability by segment. However, by our estimates, specialty eggs are meaningfully more profitable than commodity eggs. Note that while Eggland’s Best branded eggs grew quickly for a number of years, most of the growth today is in the cage-free and organic business, which does not have local monopoly dynamics (although it has had pricing power in recent years due to demand growth that has outstripped supply growth).

Industry

Structure

The structure of the industry is poor. Egg production is fragmented – the top ten producers have ~50% market share, and the next 40 have 40% share. There are no meaningful barriers to entry or advantages to scale beyond a de minimis size.

There are 2 dominant primary breeders of egg laying hens worldwide. Hy-line/Lohmann has dominant market share in the U.S., and does have pricing power, although primary breeders do not represent a large portion of overall costs.

Customers are also concentrated. Wal-Mart is 28% of sales for CALM, and the top ten customers are ~70% of sales.

Egg production is geographically more diversified than broiler production, although it is concentrated in the Midwest (~50% of production) near feed supplies.

Since eggs are very cheap per pound, transportation – both of feed and of eggs – can constitute up to ~20% of the total cost a wholesale egg. As a result, the relative cost position of an egg producer is driven in part by his location. Producers can either locate in the Midwest – close to feed supplies – or next to end demand. While the relative costs of trucking eggs vs. shipping feed over rail fluctuates, the cost of producing and delivering eggs to the Southeast (CALM’s main market) from the Midwest has generally been a little bit cheaper than producing eggs in the Southeast. The best evidence that there was an advantage to producing in the Midwest was the rapid growth of supply there and decline in other states (see below). This is especially true for “breaker eggs” which have lower shipping costs. Our research suggests that CALM is close to cost parity under current conditions. Note that temperature does not have a big impact on the cost of egg production (as it does for broiler production) because egg-laying hens are currently packed so closely together that they generate enough heat on their own to avoid the need for heating, even in Iowa winters.

Cal-Maine competes with Midwestern supply as well as Southeastern supply. Therefore, while CALM’s ~40% share of eggs produced in the Southeast is large, it is unlikely that the company has any market power given its ~15% share of the total potential supply (Midwest + Southeast).

Modern egg production is highly automated – the vast majority of commodity eggs never touch human hands before being consumed. The biggest cost in egg production by far is corn and soy-based feed (~60% recently, including the feed used to raise hens before they produce eggs). Other major costs are transportation and energy, packaging, and capital cost. As you can imagine, lower corn and soy prices have been a boon for egg producers, and will continue to be for some time.

Cyclicality

The egg industry has a long history of cyclicality, with good cause: egg demand is largely inelastic (prices have to move a lot to change demand); feed prices are highly variable; and there is a lag between price signal and supply adjustment (although a short lag).

Demand

US egg demand per capita peaked during WWII, and declined almost 50% by 1990. The post-war decline coincided with a rapid increase in meat consumption (up almost 50% per capita between 1945 and 1970). After finding something of a floor in the 60s, egg consumption per capita declined from 1970 to 1990. While this period saw slower meat consumption growth, eggs lost favor among nutritionist because of their high cholesterol content.

Egg consumption per capita recovered modestly from the late 1990 to the start of the recession, when demand for all foodstuffs declined. Since 2010 production has once again been rising, at a ~1% CAGR per capita (or ~2% in total). Many in the industry attribute the strength of the last several years to improving views of the health of eating eggs, as well as protein-heavy diet trends. In 2014, production grew ~2.3% per capita, which was the strongest growth in the last 15 years.

Rather than indicating a renewed appetite for eggs among Americans, strong growth in 2014 was likely due to protein substitution from fast food outlets due to high meat prices. In fact, all but 0.5% of that growth came from egg products (used in fast food and prepared products). McDonalds released the “Egg White Delight” in 2013, which now accounts for 10% of all egg white demand in the US – meaning that the sandwich was itself responsible for almost half of the growth in egg consumption in 2014. Other fast food restaurants have promoted egg sandwiches as well. Eggs are the cheapest form of protein (with both lower feed costs and lower processing costs than broilers), so demand should remain above trend as long as other protein prices remain high. The company’s own assumption is that egg demand will grow in line with population growth over the long term.

Supply

Collusion

Beginning in 2002, a number of large egg consumers including supermarkets and food processors sued egg producers and the United Egg Producers (“UEP”), the main egg industry trade group, alleging that the industry colluded through the UEP in order to reduce egg supply and raise prices. Customers allege that, with the guidance of Don Bell, an agriculture economist, the UEP created a 5% “supply adjustment program” in 1999 and 2000, and continued the practice of enforcing supply discipline by mandating lower hen housing densities through an “Animal Welfare” initiative (the initiative reduced ~4% of industry capacity per year from 2002-2008). The UEP audited the welfare/supply initiative and actively dissuaded buyers from purchasing eggs from non-participants (~ 96% of the industry participated). The lawsuits were for the most part settled in 2013. Quotes unearthed during discovery are pretty clear– at least some members of the industry regarded the various initiatives as a way to enforce supply discipline. Whether the UEP initiated the welfare program out of concern for the wellbeing of laying hens or as a ploy to reduce supply, industry capacity was depressed for a number of years, which likely elevated prices and returns on capital in the industry over the time period. CALM has been meaningfully more profitable, and more consistently so, post-2000 than pre-2000 (although there are only 5 years of data pre 2000). It will be presumably be much more difficult to collude post-settlement, although the industry could continue to reduce hen densities and enjoy somewhat better returns than the industry structure would suggest.

California Regulation

Even before the bird flu epidemic, there was a supply disruption because of new regulations in California.

California passed Proposition 2 in a 2008 state referendum. Proposition 2 specifies that beginning on January 1, 2015, egg-laying hens be confined only in ways that allow these animals to lie down, stand up, fully extend their limbs and turn around freely. The State legislature then passed the AB 1437 bill to extend the same requirements to eggs sold in California but produced out of state. The new law requires space per hen to increase ~75%, to ~116 square inches of space per hen (~a sheet of legal sized paper) vs. the current UEP standard of 67 square inches (~an iPad).

While the California bills were passed several years ago, there was uncertainty as to whether they would be implemented. The egg lobby challenged Proposition 2 and AB 1437 in several courts, arguing mostly that the bills interfered with interstate commerce. Further, the egg lobby and animal protectionists had ongoing discussions about forging a compromise to establish new national standards that would have been established in the long-delayed Farm Bill, finally passed in 2014 without egg-laying hen standards (the agreement would have been to move to 124 square inches over 15 years).

As a result of the California regulations, effective capacity in the industry declined ~4% nationwide on January 1. While egg prices spiked >100% in anticipation of disruption starting in November 2014, they were back down to where they started by the end of the year.

Bird Flu (Highly Pathogenic Avian Influenza, or “HPAI”)

The USDA reported the first cases of HPAI on the West Coast in December 2014, and by April, the outbreak had turned into an unprecedented epidemic affecting commercial farms in the Midwest (which produce most of the country’s eggs). To date, ~35mm layers, or more than 11% of the total flock, have been taken out of the supply base as a result of the flu, including over half of the hens in Iowa, the state with the most production and the center of the epidemic. To put this in perspective, the largest previous outbreak in the US (in 1983) was ~17 million birds. The largest previous outbreak in a developed country was the 30 million birds killed in the Netherlands in 2003, which represented 1/3rd of the flock in the Netherlands at the time (there are almost 2x as many chicken in the Netherlands as there are in Iowa, which is 4x the size).

While it is difficult to say how many more birds will be affected, John Clifford, the Chief Veterinary Officer for the U.S. Department of Agriculture, was recently quoted saying that the worst had passed. The pace of new cases discovered has been meaningfully slower over the last 10 days than it was earlier in the month, but that is no assurance that we've reached the end. The virus does not fare well in hot, dry and sunny environments; while farms have implemented biosecurity measures, a long spell of good weather is more likely to bring about an end to the epidemic. Many in the industry believe the epidemic will be over by the summer.

Farms that are hit by the virus need to euthanize and dispose of their flocks, clean their facilities, and have them approved to restart production by the USDA, a process that could take several months. Since commercial chicken begin laying eggs once they are 4-5 months old, supply could start to rebuild within ~6 months of the end of the epidemic. A good chunk of supply should be replaced within a year, although it could take 18 months or more to fully normalize due to limitations on pullet (young chicken) availability.

It’s also tough to predict how the supply disruption will affect egg prices over the period. In the short run, eggs are quite inelastic, especially at retail. Academic studies have estimated price elasticity of demand anywhere from 0.5 to 0.1, with several of the more credible studies around 0.3, meaning that for every 1% decline in production, prices would increase ~2%-~10%. Prices have more than doubled since the beginning of the outbreak. An epidemic such as this one can actually increase demand in the short run, due to “hoarding" in anticipation of the disruption worsening. Over the medium term, however, prices should moderate as fast food outlets, commercial users and others react to higher prices by reducing consumption, and, further down the line, as supply begins to normalize. Note that the impact of the supply disruption should be cushioned somewhat by export bans, farmers letting their flocks live longer, capacity increases in areas that aren't affected, and some importing (exports account for ~5% of current production).

While it is difficult to estimate the impact of the bird flu with any precision, it would take draconian assumptions to justify the current stock price. If 40mm-50mm total layers end up being affected, we estimate that CALM will generate an incremental ~$5-$10 per share of earnings. This would represent egg prices 30% to 60% higher than last year on average over the next 18 months (note that CALM sells specialty eggs under negotiated contracts which historically have only been weakly tied to spot prices; CALM is unlikely to capture the full impact of spot egg price increases). As a point of comparison, the PEDv virus outbreak which decimated the US swine population in 2014 killed ~13% of the herd. Prices spiked initially but came down substantially after six months, and averaged the year post-outbreak ~30% higher than the previous year (prices were back to previous year levels about one year post outbreak). The outbreaks are not fully comparable for several reasons (hogs have a longer life-cycle and therefore take longer to bring to market post-cleanup, but pork has closer substitutes than eggs), but it is the closest U.S. analog in recent years. For the sake of comparison, the Stephens analyst is expecting ~$6.75 in additional EPS over the next two years. She then goes on to capitalize those outsized bird flu earnings to get to her price target.

The bird flu has so far been contained in the Midwest, creating a highly favorable environment for CALM, which is mostly located in the Southeast. CALM has enjoyed the benefits of higher egg prices without seeing any loss of production. The flu could conceivably reach CALM's flock; if it were to spread, it would likely be in the fall when migratory birds fly south.

Further regulation

As discussed above, the industry had been operating under a good deal of uncertainty about future animal welfare legislation. Producers avoided adding capacity over the last several years because they did not know if new standards would be imminent. With the passage of a farm bill in 2014 devoid of nationwide standards, uncertainty has been lifted and producers are once again investing. The number of egg-laying chicks hatched, a leading indicator of supply growth, has been at unprecedentedly high levels over the last several months (up 7% y/y from January through April). Over the long term, many in the industry think that enriched cages similar to the ones adopted to meet standards in California will eventually become mandatory nationwide. As a result, new capacity is being added in the form of enrichable cages, which are designed with flexibility to accommodate rising standards over time.

Acquisitions

CALM has long been an acquirer of other egg producers. The company aims to buy producers at their depreciated asset value – although they generally pay a small premium to this. As can be seen below, they have been able to buy facilities for less than the cost of new construction.

The most recent acquisition of a conventional production facility was Maxim Production in 2012, which included all ancillary facilities including pullet growing capacity and a grain elevator, and which should be a representative transaction. CALM purchased Maxim for $20/layer, vs. adjusted historical average new construction costs of ~$25, plus ~$5 of net working capital. It is difficult for an outsider to tease out how much of the acquisition discount simply reflects the lower value of used assets.

CALM is generally buying family farms that are for sale because of a generational transition or other event. Families that are selling want to get out of the egg business – and therefore are generally unwilling to accept CALM stock. CALM went public with the idea that it could use stock as a currency but hasn’t been able to so far, with one very minor exception. The company is always on the hunt for acquisitions, but farmers haven’t wanted to sell in the current favorable environment.

CALM has historically been the sole bidder on many egg assets, although that may change. Land O’ Lakes pursued a small scale rollup starting in 2000, but the company, Moark, was poorly run and had below average profitability for the industry. Land O’ Lakes sold the assets in 2014, despite having recently upgraded their facilities. CALM bid but did not win. Opal Foods – a vehicle created by private equity firm AGR Partners – won with a ~$26/layer bid. CALM management has stated in public that they think Opal overpaid—which is meaningful in the context of CALM’s current valuation of $62/layer (net of cash, construction in progress and expected over-earning). Opal Foods may continue to be an active acquirer in the industry, which may make future acquisitions more competitive for Cal-Maine.

Overall, the value created by M&A is limited by the amount of capital which is likely to be deployed in relation to CALM’s market cap. We don’t think M&A is likely to create more than $1-$2 of value per share over the next five years.

Management

CALM is controlled by the Adams family which founded a predecessor to Cal-Maine. Former CEO Fred Adams is Chairman Emeritus and controls 30% of the company. His son-in-law, Adolphus Baker, is the CEO, and owns ~2% of the company. The board is insular – they all live in Jackson, MS. One outside director was a former partner at E&Y, while the two others work for a local bank and a local CPA firm, respectively. The firm is audited by Frost, PLLC, which is notable for a company of CALM’s size.

Normalized earnings and asset value

Based on average earnings over the last 20 years – either returns on capital or inflation-adjusted earnings per egg produced—normalized earnings for CALM are ~$1.20/share. The last ~8 years have been meaningfully better for CALM than the previous ~12 years. There are several potential explanations including potential collusion and uncertainty regarding cage size regulations (likely to reverse), but also a somewhat more consolidated industry with more rational industry participants, and growth in specialty eggs. $1.20 is the low end of our normalized earnings estimate, although you could make a good case that CALM’s earnings power is lower.

As an alternative to using historical data, we have estimated the earnings power and asset value of CALM based on a sustainable return on the capital required to expand egg capacity. Over time, egg prices should reflect the incremental cost of adding new capacity (if demand is growing). By our estimates, it costs ~$30-$35 per-layer to build conventional facilities including working capital, and ~$45 per layer for cage-free facilities. With this framework, normalized earnings at CALM should be closer to ~$1.70 at an 8% return on capital. ~$1.70 is also close to CALM’s capacity-adjusted average earnings over the last 5 years.

With earnings power of $1.20-$1.70 per share, CALM is trading at 25x-35x normalized earnings, excluding net cash, expected overearning through 2017 and construction in progress totaling ~$15/share. The company is trading at ~3x CALM’s most recent acquisition, and almost 2x our estimate of the cost to replicate the assets with new construction (again, excluding $15/share in extra assets).

Conclusion

We think CALM is an attractive short. The company is currently overearning in a low-growth commodity industry. The stock is meaningfully overvalued, even making conservative assumptions about the impact of the avian influenza. Assuming a 12x multiple of normalized earnings, we believe the stock is worth $30-$35, implying 40%-50% downside.

Key risks

-Longer than expected overearning due to the bird flu or another disruption

-More than expected accretive M&A, equity or debt issuance

-Collusion in the industry

-Regulation: while new cage standards would likely be a net negative for the industry, there are scenarios where they could help the industry for a period

I do not hold a position with the issuer such as employment, directorship, or consultancy.I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Line of sight to the end of the avian influenza outbreak

- Egg price declines

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Description

Cal-Maine Foods (CALM) SHORT

Summary

Cal-Maine (CALM), the largest producer of table eggs in the US, is up 50% is the last 3 months and almost 3x since 2013. We think shorting the stock is attractive, either outright or through long-term puts. The company is overearning in a low-growth commodity industry due to a bird flu epidemic and other factors described below. By our estimates, the stock is trading between ~25x-~35x normalized earnings, net of 2015-2017E overearning, cash, construction in progress and other assets. Assuming a 12x multiple on normalized earnings, we believe there is ~40-50% downside for the stock, with limited long-term upside.

The Business

Cal-Maine is the largest producer and marketer of table eggs in the US with ~11% market share, mostly in the southeast (especially Florida). They focus on table eggs (as opposed to “breaker eggs” which are turned into liquid or solid egg products for commercial use). The company has been an active consolidator: they have completed eighteen acquisitions since 1989. In addition to selling commodity eggs, CALM sells specialty eggs such as cage-free eggs and nutrient enriched eggs as part of the “Eggland’s Best” consortium. The company also resells eggs from other producers under “co-pack” agreements, on which it makes a small margin. For those familiar with the broiler industry, note that CALM’s model is meaningfully more capital intensive than the typical broiler integrator since CALM owns and operates the vast majority of the facilities for raising pullets and housing layers.

Specialty eggs refer to any non-commodity eggs – these are primarily Eggland’s Best eggs and cage-free and organic eggs produced under CALM’s own “Farmhouse” brand. Eggland’s Best is a consortium collectively owned by franchisees, who pay the collective a per-egg fee for every Eggland’s Best branded egg they sell. Branded eggs are fed a specific diet to produce nutritionally enriched eggs. The collective promotes the eggs and does some R&D, returning any left-over “profit” as a patronage dividend. An Eggland’s Best franchisee has the right to sell eggs in a specific “home” geographic area as well as to sell “away” in another franchisee’s “home” territory but must pay the “home” franchisee a royalty. In practice, franchisees typically mainly sell in their “home” franchises, giving Eggland’s Best franchises elements of local monopolies (although with limited pricing power due to the close substitute of other eggs). CALM owns the “Farmhouse” brand itself, which it uses for cage-free and organic eggs, but pays Eggland’s Best to promote the brand on its behalf.

The company does not disclose profitability by segment. However, by our estimates, specialty eggs are meaningfully more profitable than commodity eggs. Note that while Eggland’s Best branded eggs grew quickly for a number of years, most of the growth today is in the cage-free and organic business, which does not have local monopoly dynamics (although it has had pricing power in recent years due to demand growth that has outstripped supply growth).

Industry

Structure

The structure of the industry is poor. Egg production is fragmented – the top ten producers have ~50% market share, and the next 40 have 40% share. There are no meaningful barriers to entry or advantages to scale beyond a de minimis size.

There are 2 dominant primary breeders of egg laying hens worldwide. Hy-line/Lohmann has dominant market share in the U.S., and does have pricing power, although primary breeders do not represent a large portion of overall costs.

Customers are also concentrated. Wal-Mart is 28% of sales for CALM, and the top ten customers are ~70% of sales.

Egg production is geographically more diversified than broiler production, although it is concentrated in the Midwest (~50% of production) near feed supplies.

Since eggs are very cheap per pound, transportation – both of feed and of eggs – can constitute up to ~20% of the total cost a wholesale egg. As a result, the relative cost position of an egg producer is driven in part by his location. Producers can either locate in the Midwest – close to feed supplies – or next to end demand. While the relative costs of trucking eggs vs. shipping feed over rail fluctuates, the cost of producing and delivering eggs to the Southeast (CALM’s main market) from the Midwest has generally been a little bit cheaper than producing eggs in the Southeast. The best evidence that there was an advantage to producing in the Midwest was the rapid growth of supply there and decline in other states (see below). This is especially true for “breaker eggs” which have lower shipping costs. Our research suggests that CALM is close to cost parity under current conditions. Note that temperature does not have a big impact on the cost of egg production (as it does for broiler production) because egg-laying hens are currently packed so closely together that they generate enough heat on their own to avoid the need for heating, even in Iowa winters.

Cal-Maine competes with Midwestern supply as well as Southeastern supply. Therefore, while CALM’s ~40% share of eggs produced in the Southeast is large, it is unlikely that the company has any market power given its ~15% share of the total potential supply (Midwest + Southeast).

Modern egg production is highly automated – the vast majority of commodity eggs never touch human hands before being consumed. The biggest cost in egg production by far is corn and soy-based feed (~60% recently, including the feed used to raise hens before they produce eggs). Other major costs are transportation and energy, packaging, and capital cost. As you can imagine, lower corn and soy prices have been a boon for egg producers, and will continue to be for some time.

Cyclicality

The egg industry has a long history of cyclicality, with good cause: egg demand is largely inelastic (prices have to move a lot to change demand); feed prices are highly variable; and there is a lag between price signal and supply adjustment (although a short lag).

Demand

US egg demand per capita peaked during WWII, and declined almost 50% by 1990. The post-war decline coincided with a rapid increase in meat consumption (up almost 50% per capita between 1945 and 1970). After finding something of a floor in the 60s, egg consumption per capita declined from 1970 to 1990. While this period saw slower meat consumption growth, eggs lost favor among nutritionist because of their high cholesterol content.

Egg consumption per capita recovered modestly from the late 1990 to the start of the recession, when demand for all foodstuffs declined. Since 2010 production has once again been rising, at a ~1% CAGR per capita (or ~2% in total). Many in the industry attribute the strength of the last several years to improving views of the health of eating eggs, as well as protein-heavy diet trends. In 2014, production grew ~2.3% per capita, which was the strongest growth in the last 15 years.

Rather than indicating a renewed appetite for eggs among Americans, strong growth in 2014 was likely due to protein substitution from fast food outlets due to high meat prices. In fact, all but 0.5% of that growth came from egg products (used in fast food and prepared products). McDonalds released the “Egg White Delight” in 2013, which now accounts for 10% of all egg white demand in the US – meaning that the sandwich was itself responsible for almost half of the growth in egg consumption in 2014. Other fast food restaurants have promoted egg sandwiches as well. Eggs are the cheapest form of protein (with both lower feed costs and lower processing costs than broilers), so demand should remain above trend as long as other protein prices remain high. The company’s own assumption is that egg demand will grow in line with population growth over the long term.

Supply

Collusion

Beginning in 2002, a number of large egg consumers including supermarkets and food processors sued egg producers and the United Egg Producers (“UEP”), the main egg industry trade group, alleging that the industry colluded through the UEP in order to reduce egg supply and raise prices. Customers allege that, with the guidance of Don Bell, an agriculture economist, the UEP created a 5% “supply adjustment program” in 1999 and 2000, and continued the practice of enforcing supply discipline by mandating lower hen housing densities through an “Animal Welfare” initiative (the initiative reduced ~4% of industry capacity per year from 2002-2008). The UEP audited the welfare/supply initiative and actively dissuaded buyers from purchasing eggs from non-participants (~ 96% of the industry participated). The lawsuits were for the most part settled in 2013. Quotes unearthed during discovery are pretty clear– at least some members of the industry regarded the various initiatives as a way to enforce supply discipline. Whether the UEP initiated the welfare program out of concern for the wellbeing of laying hens or as a ploy to reduce supply, industry capacity was depressed for a number of years, which likely elevated prices and returns on capital in the industry over the time period. CALM has been meaningfully more profitable, and more consistently so, post-2000 than pre-2000 (although there are only 5 years of data pre 2000). It will be presumably be much more difficult to collude post-settlement, although the industry could continue to reduce hen densities and enjoy somewhat better returns than the industry structure would suggest.

California Regulation

Even before the bird flu epidemic, there was a supply disruption because of new regulations in California.

California passed Proposition 2 in a 2008 state referendum. Proposition 2 specifies that beginning on January 1, 2015, egg-laying hens be confined only in ways that allow these animals to lie down, stand up, fully extend their limbs and turn around freely. The State legislature then passed the AB 1437 bill to extend the same requirements to eggs sold in California but produced out of state. The new law requires space per hen to increase ~75%, to ~116 square inches of space per hen (~a sheet of legal sized paper) vs. the current UEP standard of 67 square inches (~an iPad).

While the California bills were passed several years ago, there was uncertainty as to whether they would be implemented. The egg lobby challenged Proposition 2 and AB 1437 in several courts, arguing mostly that the bills interfered with interstate commerce. Further, the egg lobby and animal protectionists had ongoing discussions about forging a compromise to establish new national standards that would have been established in the long-delayed Farm Bill, finally passed in 2014 without egg-laying hen standards (the agreement would have been to move to 124 square inches over 15 years).

As a result of the California regulations, effective capacity in the industry declined ~4% nationwide on January 1. While egg prices spiked >100% in anticipation of disruption starting in November 2014, they were back down to where they started by the end of the year.

Bird Flu (Highly Pathogenic Avian Influenza, or “HPAI”)

The USDA reported the first cases of HPAI on the West Coast in December 2014, and by April, the outbreak had turned into an unprecedented epidemic affecting commercial farms in the Midwest (which produce most of the country’s eggs). To date, ~35mm layers, or more than 11% of the total flock, have been taken out of the supply base as a result of the flu, including over half of the hens in Iowa, the state with the most production and the center of the epidemic. To put this in perspective, the largest previous outbreak in the US (in 1983) was ~17 million birds. The largest previous outbreak in a developed country was the 30 million birds killed in the Netherlands in 2003, which represented 1/3rd of the flock in the Netherlands at the time (there are almost 2x as many chicken in the Netherlands as there are in Iowa, which is 4x the size).

While it is difficult to say how many more birds will be affected, John Clifford, the Chief Veterinary Officer for the U.S. Department of Agriculture, was recently quoted saying that the worst had passed. The pace of new cases discovered has been meaningfully slower over the last 10 days than it was earlier in the month, but that is no assurance that we've reached the end. The virus does not fare well in hot, dry and sunny environments; while farms have implemented biosecurity measures, a long spell of good weather is more likely to bring about an end to the epidemic. Many in the industry believe the epidemic will be over by the summer.

Farms that are hit by the virus need to euthanize and dispose of their flocks, clean their facilities, and have them approved to restart production by the USDA, a process that could take several months. Since commercial chicken begin laying eggs once they are 4-5 months old, supply could start to rebuild within ~6 months of the end of the epidemic. A good chunk of supply should be replaced within a year, although it could take 18 months or more to fully normalize due to limitations on pullet (young chicken) availability.

It’s also tough to predict how the supply disruption will affect egg prices over the period. In the short run, eggs are quite inelastic, especially at retail. Academic studies have estimated price elasticity of demand anywhere from 0.5 to 0.1, with several of the more credible studies around 0.3, meaning that for every 1% decline in production, prices would increase ~2%-~10%. Prices have more than doubled since the beginning of the outbreak. An epidemic such as this one can actually increase demand in the short run, due to “hoarding" in anticipation of the disruption worsening. Over the medium term, however, prices should moderate as fast food outlets, commercial users and others react to higher prices by reducing consumption, and, further down the line, as supply begins to normalize. Note that the impact of the supply disruption should be cushioned somewhat by export bans, farmers letting their flocks live longer, capacity increases in areas that aren't affected, and some importing (exports account for ~5% of current production).

While it is difficult to estimate the impact of the bird flu with any precision, it would take draconian assumptions to justify the current stock price. If 40mm-50mm total layers end up being affected, we estimate that CALM will generate an incremental ~$5-$10 per share of earnings. This would represent egg prices 30% to 60% higher than last year on average over the next 18 months (note that CALM sells specialty eggs under negotiated contracts which historically have only been weakly tied to spot prices; CALM is unlikely to capture the full impact of spot egg price increases). As a point of comparison, the PEDv virus outbreak which decimated the US swine population in 2014 killed ~13% of the herd. Prices spiked initially but came down substantially after six months, and averaged the year post-outbreak ~30% higher than the previous year (prices were back to previous year levels about one year post outbreak). The outbreaks are not fully comparable for several reasons (hogs have a longer life-cycle and therefore take longer to bring to market post-cleanup, but pork has closer substitutes than eggs), but it is the closest U.S. analog in recent years. For the sake of comparison, the Stephens analyst is expecting ~$6.75 in additional EPS over the next two years. She then goes on to capitalize those outsized bird flu earnings to get to her price target.

The bird flu has so far been contained in the Midwest, creating a highly favorable environment for CALM, which is mostly located in the Southeast. CALM has enjoyed the benefits of higher egg prices without seeing any loss of production. The flu could conceivably reach CALM's flock; if it were to spread, it would likely be in the fall when migratory birds fly south.

Further regulation

As discussed above, the industry had been operating under a good deal of uncertainty about future animal welfare legislation. Producers avoided adding capacity over the last several years because they did not know if new standards would be imminent. With the passage of a farm bill in 2014 devoid of nationwide standards, uncertainty has been lifted and producers are once again investing. The number of egg-laying chicks hatched, a leading indicator of supply growth, has been at unprecedentedly high levels over the last several months (up 7% y/y from January through April). Over the long term, many in the industry think that enriched cages similar to the ones adopted to meet standards in California will eventually become mandatory nationwide. As a result, new capacity is being added in the form of enrichable cages, which are designed with flexibility to accommodate rising standards over time.

Acquisitions

CALM has long been an acquirer of other egg producers. The company aims to buy producers at their depreciated asset value – although they generally pay a small premium to this. As can be seen below, they have been able to buy facilities for less than the cost of new construction.

The most recent acquisition of a conventional production facility was Maxim Production in 2012, which included all ancillary facilities including pullet growing capacity and a grain elevator, and which should be a representative transaction. CALM purchased Maxim for $20/layer, vs. adjusted historical average new construction costs of ~$25, plus ~$5 of net working capital. It is difficult for an outsider to tease out how much of the acquisition discount simply reflects the lower value of used assets.

CALM is generally buying family farms that are for sale because of a generational transition or other event. Families that are selling want to get out of the egg business – and therefore are generally unwilling to accept CALM stock. CALM went public with the idea that it could use stock as a currency but hasn’t been able to so far, with one very minor exception. The company is always on the hunt for acquisitions, but farmers haven’t wanted to sell in the current favorable environment.

CALM has historically been the sole bidder on many egg assets, although that may change. Land O’ Lakes pursued a small scale rollup starting in 2000, but the company, Moark, was poorly run and had below average profitability for the industry. Land O’ Lakes sold the assets in 2014, despite having recently upgraded their facilities. CALM bid but did not win. Opal Foods – a vehicle created by private equity firm AGR Partners – won with a ~$26/layer bid. CALM management has stated in public that they think Opal overpaid—which is meaningful in the context of CALM’s current valuation of $62/layer (net of cash, construction in progress and expected over-earning). Opal Foods may continue to be an active acquirer in the industry, which may make future acquisitions more competitive for Cal-Maine.

Overall, the value created by M&A is limited by the amount of capital which is likely to be deployed in relation to CALM’s market cap. We don’t think M&A is likely to create more than $1-$2 of value per share over the next five years.

Management

CALM is controlled by the Adams family which founded a predecessor to Cal-Maine. Former CEO Fred Adams is Chairman Emeritus and controls 30% of the company. His son-in-law, Adolphus Baker, is the CEO, and owns ~2% of the company. The board is insular – they all live in Jackson, MS. One outside director was a former partner at E&Y, while the two others work for a local bank and a local CPA firm, respectively. The firm is audited by Frost, PLLC, which is notable for a company of CALM’s size.

Normalized earnings and asset value

Based on average earnings over the last 20 years – either returns on capital or inflation-adjusted earnings per egg produced—normalized earnings for CALM are ~$1.20/share. The last ~8 years have been meaningfully better for CALM than the previous ~12 years. There are several potential explanations including potential collusion and uncertainty regarding cage size regulations (likely to reverse), but also a somewhat more consolidated industry with more rational industry participants, and growth in specialty eggs. $1.20 is the low end of our normalized earnings estimate, although you could make a good case that CALM’s earnings power is lower.

As an alternative to using historical data, we have estimated the earnings power and asset value of CALM based on a sustainable return on the capital required to expand egg capacity. Over time, egg prices should reflect the incremental cost of adding new capacity (if demand is growing). By our estimates, it costs ~$30-$35 per-layer to build conventional facilities including working capital, and ~$45 per layer for cage-free facilities. With this framework, normalized earnings at CALM should be closer to ~$1.70 at an 8% return on capital. ~$1.70 is also close to CALM’s capacity-adjusted average earnings over the last 5 years.

With earnings power of $1.20-$1.70 per share, CALM is trading at 25x-35x normalized earnings, excluding net cash, expected overearning through 2017 and construction in progress totaling ~$15/share. The company is trading at ~3x CALM’s most recent acquisition, and almost 2x our estimate of the cost to replicate the assets with new construction (again, excluding $15/share in extra assets).

Conclusion

We think CALM is an attractive short. The company is currently overearning in a low-growth commodity industry. The stock is meaningfully overvalued, even making conservative assumptions about the impact of the avian influenza. Assuming a 12x multiple of normalized earnings, we believe the stock is worth $30-$35, implying 40%-50% downside.

Key risks

-Longer than expected overearning due to the bird flu or another disruption

-More than expected accretive M&A, equity or debt issuance

-Collusion in the industry

-Regulation: while new cage standards would likely be a net negative for the industry, there are scenarios where they could help the industry for a period

I do not hold a position with the issuer such as employment, directorship, or consultancy.I and/or others I advise hold a material investment in the issuer's securities.